Corporate loans: an alternative to bonds?

Over the past decade, yields on many developed market bonds have declined materially. In some markets, bond yields have even turned negative with investors effectively paying for the privilege of holding bonds. It is therefore not surprising that many investors have looked for alternative sources of income that also provide protection from rising inflation and interest rates.

Corporate loans are floating-rate, senior secured debt issued by companies. They are rated below investment grade. Some countries refer to them as ‘bank loans’ or ‘senior secured loans’. They offer borrowers relatively easy access to funding compared with issuing a bond. And while the loan repayments can be more expensive compared to a corporate bond, there is more flexibility. This includes the ability to pre-pay some or all of the debt.

Meanwhile, the potential for outperformance in an environment of rising interest rates may also attract investors. Historically, corporate loans have outperformed corporate bonds when interest rates have been going up. One reason for this is that corporate loans have floating-rate coupons. If you hold a conventional bond, you don’t benefit from rising yields, because the income is fixed. Floating-rate coupons, on the other hand, mean that the holder gets more income when yields rise.

Improved capital security is another draw. Corporate loans rank higher in the capital structure than bonds or equity. This means they receive priority in payment if the company falls on troubled times. As a result, recovery rates on defaulted loans have averaged 80% historically. This compares with an average rate of around 40% for high-yielding bonds since 1982, according to research by JP Morgan. Loans have also typically had stronger covenants than bonds. This gives the lender superior protection against credit deterioration and higher compensation when risk profiles change.

Growing demand for loans

These attractions have led to substantial growth in the number of outstanding loans.

This loan market growth has come from a number of sources. Collateralised loan obligations (CLOs), vehicles which hold portfolios of loans and issue a range of securities against them, are the largest buyers of loans. The CLO market as a whole has grown substantially post-global financial crisis and has been a significant buyer of newly issued loans. In addition, the continued hunt for yield has led to increasing investment from both institutional and retail investors through products such as mutual funds and exchange-traded funds (ETFs).

This strong demand for loans has had a profound effect on the market.

This strong demand for loans has had a profound effect on the market. To take on the higher risk of holding loans (compared with holding cash) investors require a higher return. This return is expressed by the credit spread above LIBOR (the London Interbank Offered Rate). But spreads for both newly issued debt and existing loans have declined over time. Even with greater loan market volatility towards the end of 2018, the credit spread of the S&P LSTA Leverage Loan Index was just 3.5% as at 8 March 2019. This index represents the largest, most liquid loans.

Additionally, persistent demand for floating rate loans has also allowed borrowers to exert more control over deals and offer less attractive terms through weaker covenants. This has led to significant growth in “cov-lite” loans which have less stringent financial tests for borrowers. This could allow companies to take riskier investment decisions and will likely lead to lower recoveries on defaulted loans.

Our current view on corporate loans

Investors often access the asset class via specialist loans funds. However, prospective returns have declined and perceived risks to the asset class as a whole have increased. As such, ASI’s Diversified Assets team’s current preference is to gain exposure to loans via funds investing in asset backed securities (ABS). These funds, which invest in a range of credit-related securities via different risk-targeted tranches, generally include exposure to corporate loans via CLO investments. They often hold a broad range of medium-risk securities, with exposure to other asset classes such as residential and commercial mortgages. Currently, we think such funds offer increased diversification benefits and a better risk/return combination than a portfolio of corporate loans.

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